Economics 302 Sec 001 Intermediate Macroeconomic Theory and Policy Spring 2011 4 25 2011 Instructor Prof Menzie Chinn UW Madison 21 1 The Medium Run EP P There are two ways in which the real exchange rate can adjust E E or P P The aggregate demand relation in an open economy with fixed exchange rate is EP Y Y G T P M P doesn t appear but real rate does 2 of 32 21 1 The Medium Run A Aggregate t Demand D d Under U d Fixed Fi d Exchange E h R Rates t EP Y Y G T P In a closed economy the aggregate demand relation took the same form as above b except for f the h presence off the h reall money stockk M P instead d off the real exchange rate P P Under fixed exchange rates the central bank gives up monetary policy as a policy instrument This is why the money stock no longer appears in the aggregate demand relation At the same time the fact that the economy is open implies that we must include a variable that we did not include when looking at the closed economy earlier namely the real exchange rate P P 3 of 32 21 1 The Medium Run Equilibrium in the Short Run and in the Medium Run Figure 21 1 Aggregate Demand and Aggregate Supply in an Open Economy Under Fixed Exchange Rates An increase in the price level leads to a real appreciation and a decrease in output The aggregate demand curve is downward sloping An increase in output leads to an increase in the price level The aggregate supply curve is upward sloping 4 of 32 21 1 The Medium Run E ilib i Equilibrium iin th the Short Sh t Run R and d in i the th M Medium di R Run The aggregate supply relation is Y P P 1 F 1 z L e The price level P depends on the expected price level Pe and on the level of output Y There are two mechanisms at work The expected price level affects nominal wages which affect price levels Higher output leads to higher employment which leads to lower unemployment higher wages unemployment wages and higher price levels levels 5 of 32 21 1 The Medium Run E ilib i Equilibrium iin th the Short Sh t Run R and d in i the th M Medium di R Run Figure 21 2 Adjustment under Fixed Exchange Rates The aggregate gg g supply pp y curve shifts down over time leading to a decrease in the price level to a real depreciation and to an increase in output p The process ends when output has returned to its natural level 6 of 32 21 1 The Medium Run Th Case The C for f and d against i t a Devaluation D l ti Figure 21 3 Adjustment with a Devaluation A devaluation of the right g size can shift aggregate demand to the right moving the economy to point C At point C output is back to the natural level of output 7 of 32 The Return of Britain to the Gold Standard Keynes versus Churchill The gold standard was a system in which each country fixed the price of its currency in terms of gold and stood ready to exchange gold for currency at the stated parity 8 of 32 21 2 Exchange Rate Crises under Fixed Exchange h Rates Suppose a country is operating under a fixed exchange rate and that fi financial i l investors i start believing b li i there h may soon be b an exchange h rate adjustment The real exchange rate may be too high the domestic currency may b overvalued be l d Internal conditions may call for a decrease in the domestic interest rate a decrease in the domestic interest rate cannot be achieved under d fixed fi d exchange h rates t If credible then what is true is it i t 9 of 32 E Et Et e t 1 21 2 Exchange Rate Crises under Fixed Exchange h Rates Expectations that a devaluation may be coming can trigger an exchange rate crisis The government and central bank have a few options They can try to convince markets they have no intention of devaluing The central bank can increase the interest rate Eventually the choice for the central bank becomes either to increase the interest rate or to validate the market s expectations and devalue 10 of 32 The 1992 EMS Crisis Figure 1 Exchange Rates of Selected European Countries Relative to the Deutsche Mark January 1992 to December 1993 11 of 32 21 3 Exchange Rate Movements under Flexible Exchange Rates Take the interest parity condition Et 1 it 1 it e Et 1 Multiply both sides by Ete 1 1 it e Et Et 1 1 it Then Th write it th the equation ti ffor year t 1 rather th th than ffor year t t 12 of 32 1 it 1 e Et 1 Et 2 1 it 1 21 3 Exchange Rate Movements under Flexible l ibl Exchange h Rates The expectation of the exchange rate in year t 1 held as of year t is given by 1 i e e Et 1 Et 2 e 1 it 1 e t 1 e E Replacing t 1with the expression above gives 1 it 1 ite 1 e Et Et 2 e 1 it 1 it 1 Continuing to solve forward in time in the same way we get 1 i 1 i 1 i E 1 i 1 i 1 i t 13 of 32 e e t t 1 t n e e t t 1 t n E e t n 1 21 3 Exchange Rate Movements under Flexible Exchange Rates Exchange Rates and Current and Future Interest Rates Any factor that moves the current or expected future domestic or foreign interest rates between year t and t n moves the current exchange rate Exchange g Rate Volatilityy The relation between the interest rate it and the exchange rate Et is all but mechanical mechanical A country that decides to operate under flexible exchange rates must accept that it will be exposed to fluctuations over time 14 of 32 21 4 Choosing betw Exchange Rate Regimes Should countries choose flexible exchange rates or fixed exchange rates In the short run under fixed exchange rates a country gives up its control of the interest rate and the exchange rate Al Also anticipation ti i ti that th t a country t may be b about b t tto d devalue l it its currency may lead investors to ask for very high interest rates An argument against flexible exchange rates is that they may move a lot and may be difficult to control them through monetary policy 15 of 32 21 4 Choosing betw Exchange Rate Regimes In general flexible exchange rates are preferable There are however two exceptions First when a group of countries is already tightly integrated a common currency may be the …